2 Top Strategies for Investors to Play Sentiment-Based Risk

Options require less dollar exposure and provide stronger profit potential

Senior Vice President of Research
Feb 22, 2021 at 9:05 AM
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If you use the SPX’s channel to chart its course over the next week, resistance comes into play at 3,940 at the beginning, and 3,955 at the end…The SPY 395 strike, equivalent to the SPX 3,950, is home to almost 100,000 calls, most of which were bought-to-open…If the SPY remains below $395, a headwind could creep into play, as long futures positions related to the call open interest at that strike are liquidated as expiration nears. This scenario would be consistent with the SPX remaining in the channel...”

          - Monday Morning Outlook, Feb. 16, 2021

Whether it was channel or option-related resistance, or a combination of both, there was limited upside action in the S&P 500 (SPX - 3,906.71) to begin a shortened expiration week. Resistance came into play in the 3,950 area, or 395 strike, if you focus on the SPDR S&P 500 ETF Trust (SPY - 390.03).  

After the SPX was unable to take out channel resistance, stocks drifted lower on Wednesday and Thursday. Some of the selling could be related to an unwinding of long positions associated with the heavy call open interest at the 395 strike, as discussed in last week’s commentary.

But as you can see on the chart below, the drift lower was hardly something that would scare optimistic traders, who have been buying call options relative to put options at an extremely high rate of more than three to one for several weeks now.

MMO 1222 1

A couple of differences as we enter this week’s trading: For one, the expiration of options will not be as influential this week relative to the standard, third Friday of the month expiration week. Moreover, whereas the SPX entered last week with channel resistance just overhead, last week’s pullback and the channel’s slope leave room for upside, should stocks head in that direction. For example, channel resistance comes into play at 3,975 by the end of this week, or 20 points above the site of channel resistance last Friday.

While the lower boundary of channel support has also risen slightly relative to last week’s 3,810-3,825 range, there is still more downside potential for the SPX to the 3,830-3,850 area, which defines the lower channel this week. And if the SPX were to break below channel support, the rising 50-day moving average -- which marked its late-January low -- sits at 3,790, or 34 points above the benchmark's 2020 close, which may acts as another area of support.

I still prefer the small-cap space. Not only is there more short-covering potential in this space -- as I have been highlighting since mid-December -- but the technical backdrop looks firmer. For example, the Russell 2000 Index (RUT - 2,233.33) never dipped below its 30-day moving average, nor did it come remotely close to moving below its 2020 close of 1,975.”

          - Monday Morning Outlook, Feb. 8, 2021

Small-cap stocks, as represented by the Russell 2000 Index (RUT - 2,266.69), were not insulated from the pullback. But per the chart below, last week’s trough was interesting because it happened at the short-term 20-day moving average, as well as a trendline that connected multiple lows from March through July of 2020. If you extend this trendline, it came into play as a short-term resistance level in late December, ahead of the early-January breakout. 

Last week’s RUT low was far above the 2,175 area, which is a round 10% above the 2020 close, and 50% above the September closing low. There was a slight pullback from this level in late January, which represents another area of support.

MMO 1222 2

There is risk in the market from a sentiment-based perspective, but that has been the case since early December, and the risk has been downgraded due to a strong technical backdrop.

Options still give you a way to play the sentiment-based risk, either through equity exchange-traded fund (ETF) puts to hedge long stock positions, or by substituting call options in lieu of stock plays to play momentum names. Options, as you have repeatedly heard in this commentary, require less dollar exposure than stock plays, and the leverage they provide gives you strong profit potential.

Another way to recognize the sentiment-based risk is to reduce large-cap exposure, while retaining exposure to small-cap equites. As I have been explaining since December, small caps have more short-covering potential, and should be emphasized in your portfolio. 

Last week, I noted these stocks have not been the subject of the option buyer optimism many market commentators, including myself, have observed. In fact, I pointed out that the ratio of puts being bought relative to calls on iShares Russell 2000 ETF (IWM - 225.19) components is indicative of pessimism that has occurred near market-bottoming levels, unlike the all-equity, buy-to-open put/call volume ratio that is at record lows. 

Per the chart below, the pessimism on display last week among small-cap option buyers on IWM component stocks is beginning to unwind quickly, with the ratio turning sharply lower. It still has room to run even lower, though, before moving into territory that represents higher risk in this group, from a very short-term perspective.

MMO 1222 3

Finally, since I have not discussed volatility -- as measured by the Cboe Volatility Index (VIX -  22.05) -- for the past couple of weeks, I invite you to read Senior Quantitative Analyst’s Rocky White commentary. In the latest Indicator of the Week, he discusses the historical implications for the market in the rare event that the VIX closes below the 20 mark, after being above that level for six months. This study was prompted by the VIX’s Feb. 12 close below 20, which happened for the first time in 246 trading days.  

Todd Salamone is Schaeffer's Senior V.P. of Research

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